Wednesday, February 2, 2011

What is Your Portfolio's Principal?

Many investors who live off their investments use the rule of thumb that you can spend the interest you make, but shouldn’t touch your principal. I’ve found this way of thinking common among those who are now well into their retirements. However, their notions of what “principal” means aren’t necessarily useful.

The idea behind this rule of thumb is sensible enough. If your savings are adequate to produce enough return to live on and you never spend your principal, then you should be set for life.

GIC Investors

For GIC investors, the most common notion of principal is a fixed number of dollars. A retiree with $500,000 in GICs feels that he can safely spend the interest from the GICs. These investors long for the good old days when interest rates were high and they had more interest to live on.

The problem with this thinking is inflation. Each year the $500,000 of principal will have less purchasing power than it had the year before (unless there is deflation). Many people who lived off interest through the 1980s learned this the hard way. When inflation and interest rates dropped, they felt the double-whammy of earning less interest on a lump sum that was severely hammered by past inflation.

Dividend Investors

Investors who live off dividends tend to view principal as the number of shares or units they own. The dividends are then money that they can freely spend. This can work reasonably well for solid dividend-paying stocks. These stocks may earn a capital gain above inflation as well as dividends which would make this strategy a little bit too conservative.

Where this strategy falls down is when the retiree owns stocks or trusts that pay unusually high dividends. In these cases the shares or units themselves are likely to go down in value; the high dividends are actually partially a return of capital. Investors in this position are essentially spending some principal without realizing it.

What Should “Principal” Mean?

The best definition I have for principal is a fixed inflation-adjusted number of dollars. This means that an investor who doesn’t want to dip into principal must see to it that the inflation part of the overall return each year goes untouched.

This approach presents its own problems. For example, a GIC investor may find that there isn’t enough interest after paying taxes to keep up with inflation even if he doesn’t spend any of the interest. For those who own equities there will be some years when equity prices go down and it is impossible to keep up with inflation.

It turns out that the “spend the interest and don’t touch the principal” strategy can be tricky to define and even trickier to follow successfully.

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